March 20, 2013

Subprime Securitization Returns--Without the Subprime

It was only a matter of time until credit markets sufficiently stabilized and investor appetite for risk grew that we would see the return of the types of securitization deals that were central to the subprime financial crisis of 2008.

One of these deal types is private-label mortgage securitization, which involves creating securities backed by pools of mortgages that are not insured by the federal government. The other deal type is synthetic securitization, which involves creating securities by grouping together the cash flows obtained by protection sellers in credit default swap derivatives.

Citigroup Inc. is among banks that have sold as much as $1 billion of synthetic collateralized debt obligations this year, following $2 billion in all of 2012, according to estimates from the New York-based lender.

There are several important differences between these new deals and their subprime counterparts, however.

And the differences make them safer.

First and foremost is the fact that they are not transferring the risk of subprime mortgages. The JP Morgan deal is bundling relatively safe jumbo prime mortgages where borrowers put down 35% of the downpayment and have high credit scores. And while the deal's relatively weaker repurchase liability for JP Morgan seems to make it riskier for investors, that characteristic seems more like a feature than a bug. That's because it had the effect of the deal carrying a greater level of loss buffers (credit enhancement) than similar deals, which is probably ultimately more valuable to investors than any right to put the securities back to the issuer.

For its part, the Citigroup synthetic deal transfers the risk of corporate loans, which is a class of credits far less risky and much better understood than subprime mortgages. It is also not a rated transaction that creates "securities" per se, which removes any problem with investors improperly relying on inflated credit ratings.

Synthetic and private-label securitization structures are not inherently risky. But they were given a very bad reputation by the mispriced subprime risk they attempted to transfer. Accordingly, these types of deals should be viewed with at least some optimism for potentially reflecting the maturing of credit markets and the positive evolution of securitization.